When you build a portfolio, you want to manage the risk and returns. Every investor wants the greatest returns, but that doesn’t always happen. But, if you don’t take some risk, your chance of high returns are minimal.
Take, for example, government bonds. This investment’s risk is minimal. Unless the government goes bankrupt, you’ll earn your returns. Will the returns be high? Most bonds have low returns because of their predictability.
A higher risk investment, such as equity investments (stocks) for example, may have a higher rate of return because of the higher risk. There’s no guarantee that the stock’s price will increase and that you’ll earn a return.
There’s value in taking a risk, but there’s also the risk that you’ll lose your entire investment. How do you decide what’s right for you?
The Incentive to Take Risk
There’s an incentive in taking a risk. The higher the risk you take, the higher your returns may be. Again, there’s no guarantee of that return, though. You could walk away with nothing. That’s why you need to determine your risk tolerance.
Where do you stand? Can you stand to lose your entire investment or do you need to lower the risk? Young investors can often take higher risks because they have more time to ‘ride it out.’ If you lose it all, you aren’t near retirement, so you can try to make the money back.
An investor closer to retirement, though, has a lot more to lose. This investor doesn’t have the time to make up for a major loss. Investors closer to retirement do well with conservative or non-risky investments with lower rates of return.
When assessing your risk tolerance, ask yourself:
- How long do you have until retirement?
- How set are you for retirement?
- What is your potential for future earnings?
- How capable are you to replace lost funds?
- What other assets/investments do you have?
What are the Typical Risks?
You can’t predict any investment. They are all volatile to some degree. But, you can use an asset class’s history to see what risks an investment may pose.
- Bonds – Bonds are debt. You lend money to the government or a company in exchange for a specific interest rate. You earn cash payments (interest payments) throughout the term. At maturity, you receive your principal bank. You can predict your returns (for the most part) and take a little risk. Bonds have a low risk and a low rate of return.
- Equities – Stocks are equities. You have ownership of the company. This may be directly through stock ownership. You may also have ownership through ETFs or mutual funds, which are indirect ownership assets. Equities, whether stocks, ETFs, or mutual funds all have a higher risk. You stand to lose more, but if the equity does well, you stand to gain more. Unlike bonds, there’s no guarantee of the return of your principal. Equities have a higher risk and a higher rate of return.
- Alternative investments – Real estate investments, private equity, and peer-to-peer loans are all alternative investments. The rate of return varies based on what’s entailed. Peer-to-peer loans, for example, may have a high risk if you choose a borrower with a low credit score. They may also have a low risk if you choose a borrower with great credit and qualifications. Your rate of return will be directly affected by the risk.
- Cash – Don’t forget about cash. Sure, you could hold it in your bank account, as that’s about as liquid as it comes. But a few investments, like US treasury notes, are just as liquid as cash and have little to no risk.
The Bottom Line
Risk and return have a direct relationship. If you’re in a position to accept some risk, you may earn great returns. But there’s the chance of a great loss too. Make sure you look at both sides and that you’re comfortable with what can happen either way. Don’t expect a return, especially a high one; always prepare yourself for the worst so you know you can handle the outcome should it happen.
Diversifying your portfolio is the best way to offset risk. If you have investments with a high risk that you want to try, offset it with a stable, low-risk investment like bonds or preferred stock. Diversifying or not putting all of your eggs in one basket helps offset the loss.